This Restaurant Is Growing Faster Than Chipotle, and Darden Owns It

Nation's Restaurant News is known as the bible of the food industry. It covers the restaurant space like no other source. Every year it releases its Top 100 Report, which measures how the different restaurant chains stack up against one another.

This year's report was an especially interesting one for me due to my coverage of Darden Restaurants (NYSE: DRI  ) . Yard House, which Darden bought for $585 million in 2012, was ranked as the No. 2 fastest-growing chain. This is ahead of Chipotle Mexican Grill (NYSE: CMG  ) , which came in at No. 4 on the list.

A tale of two companies
It's not often that Darden Restaurants gets put in the same category as Chipotle. Darden Restaurants has been a perennial underperfomer in the restaurant industry for the past several years. For more than three years, shares of Darden Restaurants have been stuck between $40 and $50 for most of that time. Chipotle, on the other hand, has risen more than threefold during the same time frame. 

Source: Chipotle Mexican Grill

Darden's strategy was formulated by Chairman and CEO Clarence Otis, who has been with the company in various roles since 1995. Otis has held the CEO title since November 2004 and the chairman's title since November 2005, so Darden's underperformance falls squarely on his shoulders. His strategy has been to assemble a portfolio of restaurants, which can then share selling, general, and administrative expenses.

Source: Darden Restaurants

The problem is things haven't worked out too well. Darden has some of the lowest margins in the business; its gross margin is only 20%, and its operating margin is 5.2%. Chipotle fares much better; it has a gross margin of 26% and an operating margin of 16%. Chipotle and Darden both own all of their restaurants and have avoided the franchising route.

The purchase of Yard House looks to be a smart move
Darden groups Yard House into its specialty restaurant group, which also includes Seasons 52, Eddie V's, Bahama Breeze, and The Capital Grille. Yard House is one of the few casual-dining concepts that appeals to a younger generation. It offers a wide menu of beers with about 130 beers on tap, a great menu, and a lively atmosphere.

Source: Yard House

The reason why Nation's Restaurant News chose Yard House is because the chain grew by 18% in the last year. Yard House now has 52 locations, which averaged $8.2 million in sales in Darden's 2014 fiscal year. This was the highest per-restaurant average among all Darden's concepts. Furthermore, if you compare it to the average Olive Garden's $4.4 million in sales and the average Chipotle at slightly more than$2 million, you get the picture of how valuable Yard House is to Darden.

Source: Yard House

The one negative for Yard House is that same-restaurant sales increased by only 0.3% in the latest fiscal year. However, this does not take into account the eight new Yard House restaurants that opened during the fiscal year. Furthermore, when you look at the sales turnover at the average location, it looks like the average location is operating at or near full capacity. The key to Yard House's growth is more restaurant openings. With Darden's financial backing, this looks to be the game plan for growth.

The purchase also gave Darden Yard House's management team and its executive chef. Harald Herrmann has been with Yard House every step of the way since it was founded by Steele Platt in 1996. Darden's chief executive Otis has been so impressed with the work Herrmann has done that he made him the head of the entire specialty restaurant group. Overall, the specialty division is Darden's fastest-growing segment. Last quarter, it posted a sales increase of more than 15% across all brands.

Foolish final thoughts
When one sees how well Yard House and the other specialty restaurants are doing in Darden's portfolio, it does support the notion that Darden is worth more separate than as a whole. Activist investors Barrington Capital and Starboard Value see this, and that's why they want Darden to break up. Darden's Otis is opposed to this because he is the architect who built Darden into what it is today. Unfortunately, his model has Darden underperforming not only Chipotle but the S&P 500 index as well.

The good news is that it should all be decided in September. That's when Darden has its annual meeting, and Starboard Value has nominated its own slate of directors. Come September, shareholders get to decide what path they want--either stick with the status quo and the existing board and management team, or go for change and vote with Starboard Value. It certainly shall be an interesting annual meeting, and one this Fool is looking forward to it.

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